Deciding on whether to buy a life insurance policy usually comes down to choosing either permanent policies such as whole life insurance or the shorter-term option of term life insurance. Picking between the two requires carefully looking at the pluses and minuses, including the tax implications of both plans.

We asked Jarrett Topel, a financial advisor and a member of NerdWallet’s Ask an Advisor network, to outline some of the key tax advantages and disadvantages of whole life policies and offer consumer tips for making the right decision.

What are the tax advantages of whole life?

The first main tax advantage of whole life insurance is the tax-free death benefit — the money you paid into the policy is distributed to your beneficiaries upon your death, tax-free (as is the case with term life insurance, if the policyholder dies during the covered term). Also, if managed correctly, whole life policies can provide tax-free loans to the owner. These loans come directly out of the death benefit that would go to your beneficiaries and do not need to be paid back (again, assuming the policy is managed correctly). These loans can provide a source of cash that can be used for a variety of reasons, such as college funding or supplemental retirement income.

What are the potential pitfalls?

One potential pitfall with whole life policies and their associated tax-free loans is that, if not managed correctly, the policy loan can become taxable, often at exactly the time the client can least afford it. This can happen if the policy lapses or is surrendered. Also, keep in mind that if the policy loan plus any interest accrued on that loan gets to be larger than the actual cash value available in the policy, you may have to put more money into the policy or the policy may be terminated by the insurance company, potentially creating a taxable event.

For example, let’s say the policy has a cash value of $10,000, and the holder takes a policy loan of $9,000. If the interest on this loan is also being paid from the cash value (which is now only $1,000 due to the $9,000 loan), then once you have more than $1,000 in accumulated interest, your total original loan ($9,000) plus interest paid or payable ($1,000-plus) will be greater than the available $10,000 original cash value.

In this situation, you will need to either fund the policy with more money or let it lapse, in which case the loan becomes taxable. The lesson is that policyholders need to be careful how and when they access the cash value of their policies.

Another potential pitfall with whole life policies is that they are generally more expensive than buying term insurance, which covers a set number of years. If someone buys a whole life policy and then cannot afford to continue paying premiums because they have an unexpected financial or health event (for example, being laid off or needing to take time off work), often the consumer ends up paying more than needed for the insurance coverage and eventually lets the policy lapse when he or she can no longer afford premiums. In this scenario, the consumer never got to take advantage of the tax-free cash value part of the policy and paid more for insurance coverage that would have been cheaper under term insurance.

How do these factors affect other parts of retirement planning?

While the tax advantages of using whole life insurance can be enticing, you have to weigh this benefit against the possibly lower overall returns you may receive if you are using your whole life policy as an investment vehicle for retirement. The cash value (investment side) of whole life polices often pay interest in the range of 1% to 3% per year. So the question becomes, can you reach your retirement goals at 1% to 3% interest? The answer to this question, for most people, is a resounding no.

As such, the guaranteed return might “feel” good to the average investor, but in reality it may only guarantee that he or she can never afford to retire. This is why we so often recommend clients buy term insurance and invest the difference (the savings from the lower insurance cost) into a diversified portfolio of mutual funds and/or exchange-traded funds.

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